The (Scientific) Method Behind Modern Investing

To better understand why Asset Allocation and Diversification are so important, we turn to mountains of research by Nobel prize-winning economists.

Modern Portfolio Theory and Diversification

In 1990, Harry Markowitz, Ph.D., he was awarded the Nobel Prize in Economics for his research on the optimization of portfolios along what he calls the Efficient Frontier. He knew that people sought the best returns possible given their risk tolerance, and showed that diversification could be used to create a portfolio that minimized risk for each given level of return. He also demonstrated that the only way to improve returns was to increase risk, as measured by stock volatility.

To understand the importance of diversification, we must understand the types of risks associated with any investment. The most intuitive risk with a stock or market sector is that the underlying company will experience hardship or failures for reasons unique to it or to its industry. Maybe it is the target of a large government enforcement action. Or perhaps its CFO is caught embezzling money or misreporting earnings. Or perhaps a natural disaster wipes out an essential resource, like a particular crop or a critical piece of a supply chain (e.g., oil pipelines).

A famous example used to describe diversification is the street vendor comparison. Vendor 1, Amy, sells sunglasses and sandals, while Vendor 2, Brittany, sells sunglasses and umbrellas. Amy might sell both of her products to the same customers at the same time. Her sales are “positively correlated” because they are both in demand on sunny days. Brittany, by contrast, will rarely sell both items to the same customer on the same day. Her sales are “negatively correlated.”

While Amy may make more money than Brittany over the course of a sunny summer season, one rainy summer could put her out of business. Brittany, by contrast, will not make as much money as Amy on sunny days, but has minimized her chances of losing money on any given day.

A single bank is more likely to go bankrupt than its entire cohort of similarly sized banks. There is also more volatility in investing in a single stock as opposed to the whole market. If you spread your risk across hundreds of stocks, the companies that underperform will have little effect on your portfolio.